Morningstar

Davidson choses to estimate each fund's individual alpha by "regressing each fund's net-of-fees return against its Morningstar category average return."

He writes that "we are left with a time series of alpha for each fund, which will form the basis of the probability distribution. Essentially, this would answer the question, 'What is my expected 12-month alpha for any given fund at any given time in a certain category?'"

Among the Morningstar sectors that Davidson determines are most likely to give investors funds that outperform a benchmark: tactical allocation, health care, utilities, communications, and industrials.

And the sectors that generate the greatest inability to outperform the indexes include several muni-bond and government-bond categories.

"I am not advocating that investors build their portfolio solely out of funds where alpha can be reliably found—replacing broad U.S. equity funds with sector stock funds," writes Davidson. "On the contrary, this analysis should merely aide the investor in deciding where it may be advantageous to scour about for an active rather than passive fund to fit an already predetermined allocation."

One needn't conduct rigorous analysis to determine that bond funds would lack the kind of return dispersion to yield good alpha-chasing potential. Still, the analysis does have merit.

Crossing Wall Street

He divided all the days into two groups: those with daily changes greater than 1.25%, (which he viewed as volatile days) and those with changes of less than 1.25%.

"The direction of the change, up or down, didn't matter. I only looked at daily volatility," he added. "The results were eye-opening. In terms of market performance, low volatility demolished high volatility. It wasn't even close. The low-vol group, taken together, accounted for the market's entire gain spread over 56 years. But the high-volatility days, coming an average of once every seven days, were net losers. Annualized, low volatility returned an average of 8.9% per year, while the high-volatility group lost 5.9% per year. In simple terms, scared markets are bad markets."

Meanwhile, another thoughtful blogger, Cullen Roche of Pragmatic Capitalism, fills us in on another important market truth: There is a "negativity bias" to market behavior and this pessimism that actually proves beneficial to smart investors who are aware of its existence.

Pragmatic Capitalism

"Fear of bad events plays a much more substantial role in our thought processes than positive events," Roche writes. "And when it comes to financial markets and economics we tend to see this bias in spades. Just look at the last five years of economic recovery during which negativity seems to have swept over the economic outlook with alarming regularity. But how bad has this recovery really been relative to past recoveries?"

Referring to recent economic data, Roche considers that the numbers don't show surging gross-domestic-product growth, "but it's also not the nightmare that the mainstream media and doom and gloomers sometimes imply. In fact, there's a fair amount of good stuff that's gone on in the last five years. And one can only imagine how much better things might have been had the policy response not been so underwhelming and misguided at times.

"The point is, it's a good thing that we often focus on the negatives in our world," he adds. "That makes us more likely to make improvements, resolve problems and avoid the same problems in the future."

From an investment standpoint, it's important not to "fall into the trap of believing that things are actually much worse than they really are. Instead, it's better to understand this bias and try to analyze the economy and the financial markets with a more balanced and pragmatic perspective."